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Countercyclical Currency Risk Premia

  • Hanno Lustig
  • Nikolai Roussanov
  • Adrien Verdelhan

We describe a novel currency investment strategy, the 'dollar carry trade,' which delivers large excess returns, uncorrelated with the returns on well-known carry trade strategies. Using a no-arbitrage model of exchange rates we show that these excess returns compensate U.S. investors for taking on aggregate risk by shorting the dollar in bad times, when the U.S. price of risk is high. The counter-cyclical variation in risk premia leads to strong return predictability: the average forward discount and U.S. industrial production growth rates forecast up to 25% of the dollar return variation at the one-year horizon. The estimated model implies that the variation in the exposure of U.S. investors to world-wide risk is the key driver of predictability.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 16427.

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Date of creation: Sep 2010
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Publication status: published as Lustig, Hanno & Roussanov, Nikolai & Verdelhan, Adrien, 2014. "Countercyclical currency risk premia," Journal of Financial Economics, Elsevier, vol. 111(3), pages 527-553.
Handle: RePEc:nbr:nberwo:16427
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